The British have spoken. As of last week, 17.4 million British voters had cast their ballot to exit the European Union, compared to 16.1 million who voted to remain. The repercussions of this vote were felt almost immediately as global futures markets traded wildly, currencies made big moves, and David Cameron turned in his resignation. But is this reaction warranted? Or this this an overreaction as a result of fear and uncertainty?

The Fear

Briton’s vote to exit the European Union was an unprecedented geopolitical event. This uncertainty will most definitely lead to short/medium risks. Three types of risk are currently at play: (1) Political (2) Economic and (3) Systematic.

Political: European Union memberships has certain perks. The most obvious of these perks is in regards to cross-border trade. As a result of the Brexit, the U.K. will have to renegotiate trade deals with other European countries. The fear/risk is that Europeans will be punitive in their negotiations with the U.K to discourage other countries from leaving the European Union.

Economic: Growth forecasts for Europe were in the range of 1.5%-2% before the votes were counted. Now that the exit vote has won, GDP estimates have been revised a full percentage point lower. The fear/risk is that global economic growth will slow substantially as a result of the Brexit.

Systematic: The United Kingdom has succumbed to populism as many British citizens are concerned about the EU deciding the fate of the British people. The fear/risk is that other countries will also succumb to populism and follow suit.

In light of these risks, global markets reacted by trading largely to the downside (S&P 500 -3.59%, Dow Jones -3.38% and NASDAQ -4.12%). Markets hate uncertainty and fear and emotion can easily take over as a result.

The Facts

Nothing happens immediately. The vote to exit the European Union is not legally binding, however no British politician would commit political suicide by not enacting the will of the people. Cameron, who plans to leave office by October, will likely invoke Article 50 of the Lisbon Treaty, which begins the legal process for leaving. This legal process is expected to be complicated and lengthy, taking at least 2 years to complete. Until then, business will resume as usual.

Investors have a tendency to react emotionally instead of rationally. Emotional reactions tend to be immediate (as evidenced in the markets today), but rationality takes time as investors have a chance to digest data. The fact is that many fears/risk about the global economy are overblown and are simply as a result of the uncertainty:

Political: The U.K. plays an important role in the European economy and it would be foolish to damage trading relations through punitive actions. For example, 1 in 5 Mercedes Benz automobiles from Germany are sold in the U.K. Germany would not damage its own economics in order to make an example. The same is true for other trading partners.

Economic: The U.K. only represents 4% of global GDP. If there is a contraction in the U.K. economy, it will not have a major impact on the global economy as a whole. Additionally, the U.K. was never a part of the European Union currency bloc. It never adopted the Euro as its currency and continued to use the Pound Sterling. Therefore, the implications of the U.K leaving are not as severe as other countries (Greece).

Systematic: Populism is gaining steam throughout the world as global citizens are increasingly dissatisfied with the powers that be. Politicians, central banks and global power players have lost confidence in recent years and the people are responding. However, change takes time and the effects of those changes are never felt immediately.

Despite the facts, markets will respond negatively in the near to intermediate term. But as a long term investor, this is not reason for concern.

Exposure

Mason & Associates’ client portfolios are broadly diversified across multiple regions and asset classes. This diversification is designed to reduce volatility in the long term as part of a balanced strategy. Your portfolio may have a minority position geared towards European equities that is experiencing downside pressure. However, we do not expect to see large adverse effects as a result of these holdings. Fixed Income (bonds) is a large portion of many portfolios and is placed in client accounts for days like today. Bonds have rallied as investors take risk off and gravitate to safety.

Downward pressure on markets and increases in fear can generally present buying opportunities as investors seek to take advantage of market dislocations. The investment committee at Mason & Associates is actively monitoring client portfolios and will respond in a rational manner when taking advantage of these dislocations. If you have any additional questions or would like to discuss how the Brexit affects your portfolio, please contact Mason & Associates directly at 323-254-3072.